Perspectives on Carried Interest

While it has been a discussion topic for some 20-odd years, carried interest taxation entered the public consciousness more noisily in 2016, when presidential candidates from both sides of the aisle espoused reform to the historical long-term capital gains treatment of a General Partner’s contractual share in an investment fund’s profits. Pro-reform political rhetoric provocatively refers to such treatment as a “loophole,” suggesting that there is something untoward about the application of the long-term capital gains rate, the underlying narrative being that fund managers are “gaming the system” to the detriment of the everyday American by not being taxed at the maximum ordinary income rate. Most recently, the Carried Interest Fairness Act of 2019 (“CIFA”) proposes to treat carried interest as ordinary income, taxed at a rate of 37%, rather than the 20% capital gains rate. Ultimately, the debate centers on whether carried interest represents investment income or wage income, a judgment made muddy by past reform and the varying nature of the partnerships in question. However, beyond determining if such reform is right with respect to tax code, it should also be evaluated for its net impact on the people it purports to benefit, as well as the broader economy.

The practice of carried interest predates the current debate by centuries, with roots back to the medieval Venetian colleganza, a contractual partnership between an investor and a merchant to fund a long, risky trading voyage. The investors financed the purchase of the goods and the cost of hiring the ship, while the merchant made the trip and traded for foreign wares to be sold upon return. The profits from the trip were then split between the investor and merchant as contractually set forth in the colleganza, with neither side capable of their joint success alone. Similar parallels can be drawn from the U.S. whaling industry or our own Baltimore Clippers, fast-sailing ships that transported goods between Europe and the New World or Asia.[1] If the goods arrived safely, the captains received 20% of the share of the profit for performing transit and delivery.[2] In each of the aforementioned examples, the investor is funding the overhead of the mission and sharing a percentage of the profits with the party that undertakes the mission, a model that promotes alignment and is echoed by venture capital firms of today.

Carried interest, however, is only charged on a fund’s realized gains as agreed upon contractually within the Limited Partnership Agreement, typically at a rate of 20% for longer-term investments held over three years. Moreover, many VC funds (and we, at Greenspring Associates) structure carried interest with European Waterfall mechanisms, such that regardless of the fact that carried interest is applicable once companies are sold at a gain, and that carried interest is immediately included in each General Partner’s taxable income (assuming that the fund is delivering investment gains and positive cash flows), it is collected only after the fund has returned 100% all contributed capital, including management fees and expenses. This not only incentivizes managers to outperform, but is distinctly different from the wage income associated with management fees. Since carried interest arises from investment income, it should therefore be taxed like other investment income. Moreover, it incentivizes the General Partner to generate investment earnings for Limited Partners, rather than sitting back and collecting management fees.

The Tax Cuts and Jobs Act passed by Congress in 2017 seems to support our notion that carried interest represents investment income, increasing the required holding period from one year to more than three years for investment funds to treat any gains allocated to its General Partner as long-term. Fine with us; as illustrated below, almost half of all venture funds take at least 15 years to conclude, and most have terms of 10 years or more.

The very nature of VC, or “patient capital” is its long-term horizon, with the average time to acquisition for venture-backed companies growing from 3.5 years as of year-end in 1999 to 6.2 years in 2018, a 77% increase. Similarly, the average time to IPO for venture-backed companies has climbed from 3.5 years as of year-end in 1999 to 6.2 years in 2018, or an increase of 110%. These expanding timeframes illustrate how our work is done over a number of years, and should be viewed as a sort of private sweat-equity earned over a sustained period of time spent supporting and nurturing portfolio companies.

Conversely, short-termism in companies has significant negative effects on the broader economy, having been linked to lost growth in both GDP and jobs.[3] A McKinsey study notes, “Companies deliver superior results when executives manage to create long-term value and resist pressure from short-term investors.”

Accordingly, our role as long-term investors is far different from that of hedge fund managers or buy-out shops. As Scott Kupor, Managing Partner at Andreessen Horowitz, writes, “There is often a misconception that Venture Capitalists are like other investment fund managers in that they find promising investments and write checks. But writing the check is simply the beginning of our engagement; the hard work begins when we engage with startups to help entrepreneurs turn their ideas into successful companies...The reality is that those who are successful in our field do not just pick winners. We work actively with our investments to help them throughout the company-building lifecycleover a long period of time. We often support our portfolio companies with multiple investment rounds spanning five to ten years, or longer. We serve on the boards of many of our portfolio companies, provide strategic advice, open our contact lists, and generally do whatever we can to help our companies succeed.”[4]

Our role as venture capitalists diverges sharply from the strategies of other investment fund managers covered by the sprawling language of the Carried Interest Fairness Act who impair the market with short-term public trades or use financial engineering to generate a quick profit. Destroying the incentive mechanism for venture capitalists, who dedicate years of their time, capital and personal resources to help visionary entrepreneurs succeed, could be catastrophic to the economy. As noted by the Aspen Institute, "Risk-taking is an essential underpinning of our capitalist system, but the consequences to the corporation, and the economy, of high-risk strategies designed exclusively to produce high returns in the short-run is evident in recent market failures... Market incentives to encourage patience capital [are] likely... the most effective mechanism to encourage long-term focus by investors."

After the above-described 2017 passage of the Tax Cuts and Jobs Act increasing the required hold period from one year to three years, it’s unlikely that the vast majority of hedge funds receive long-term capital gains treatment. As a result, the Carried Interest Fairness Act would be a tax increase focused only on, and thus discouraging, longer-term investment such as Venture Capital.

Limited Upside, Broad Economic Implications

In December 2017, the Congressional Budget Office performed an independent analysis of the impact on federal revenues of treating carried interest as ordinary income, finding that there would be a mere $14 billion raised over a period of ten years.

This amounts to roughly $1.3 billion per year, a relatively small amount when compared with other tax provisions, as illustrated below by the Tax Foundation.

To put this in perspective, in 2020 alone, this would represent a scant 0.03% of the budgeted federal total spending of $4.7 trillion. Consider this alongside venture capital’s contribution to our country’s economic health in areas like research and development (R&D) and salaries, where the majority of venture-backed companies, successful or not, spend their capital. According to data from the U.S. Department of Labor and U.S. Census Bureau, new businesses create an average of 3 million new jobs each year and account for virtually all new job creation. Beyond new businesses, public venture-backed companies employ 38% of all public company workers. At a time when U.S. government research dollars are decreasing, venture-backed companies continue to invest in the future, generating 82% of the total R&D spending of all post-1979 publicly-traded companies. As noted in a study by Ilya Strebulaev of Stanford University and the National Bureau of Economic Research, "[Venture-backed companies] generated hundreds of thousands of high-skilled jobs, billions of dollars for investors, and trillions of dollars of benefit for the U.S. economy and immeasurable positive spillovers" the same study concluded "these companies have been a prime driver for both economic growth and private sector employment." This is true for us at Greenspring Associates, a venture firm based outside of Baltimore in Owings Mills, Maryland, where our direct and indirect investments in over 7,000 companies have led to more than 1 million new jobs.

Though venture capital has a substantial positive impact on the U.S. economy, it remains a small fraction of the private fund universe, where hedge funds and leverage buyout funds account for 92% of all private assets under management.[5],[6],[7] However, while venture capital is small, it casts a long shadow which towers over hedge funds and leverage buyout funds in one clear metric: the number of companies funded. Each year, VCs fund thousands of innovative companies, resulting in tens of thousands of newly created jobs.

With respect to venture capital’s role in public market performance, at present, Apple, Google, Microsoft and Amazon are four of the top-five most valuable U.S. public companies, and each received most of their early external financing from VCs. Since the markets’ rebound from its December lows through June 30, 2019, U.S. venture-backed IPOs have soared and technology has been the best performing sector of the S&P 500, representing an essential driver of U.S. growth.

Finally, contrast this with the recent efforts of a host of other countries, which are keenly focused on encouraging innovation and startup creation, to mimic the U.S. venture capital model. Twenty years ago, our country was the undisputed leader, with 94% of global venture capital invested into U.S. startups. Today our leadership has eroded, with U.S. startups' share reduced to 51% of global venture investment while Chinese startups receive 30%. Europe, in particular, is strongly supporting venture capital through their European Investment Fund (EIF) which invests in venture capital funds and committed nearly $2 billion to U.K.-based funds through 2017 alone. The EIF, in their justification for their involvement in the E.U. venture capital market, writes, “The relevance of Venture Capital financing, not only for young and innovative companies but also for the economy as a whole, ranks high in the toolbox of policy recommendations”.[8] France has increased its investment in innovation from $177 million across 33 deals in Q1 of 2012 to approximately $1.5 billion across 167 deals in Q2 2017, fueling their domestic growth.[9] Italy has implemented innovation-friendly policies as well, such as the provision for fund managers to claim carried interest as capital gains as long as they have personally invested at least 1% of a fund’s total capital. In the 2018 Global Entrepreneurship Index, European nations represent 7 out of the 10 most entrepreneurial countries. Asia, more broadly, is at the forefront of innovation, with the share of intellectual property applications filed from Asia rising from 40% in 2006 to 60% in 2016. For reference, intangible assets now comprise over 80% of S&P 500 companies’ market value, compared to just 17% in 1979. In dollar terms, this amount is equal to $5.1 trillion, or the GDP of Japan.[10]

Innovation is one of the nation’s most vital assets. As other nations copy the U.S. venture capital model and increase competition for global VC investment dollars, the CIFA would serve as a self-inflicted wound to the country and its global technological leadership. As Senator Baldwin, a sponsor of the CIFA, notes, “If our [companies] no longer attempt to develop new products, train-up workers, or expand into new ventures, our national competitiveness will suffer.”[11]

Local Economic Implications: The Rise of the Rest (or the Little Guy)

Faced with significant disruption to long-standing industries, local governments outside of the traditional, coastal hubs of venture capital have sought to stimulate their own innovation economies. Denver’s Mayor, Michael Hancock, worked with the city’s Office of Economic Development to develop a strategy to attract more venture capital investments into Denver. He later wrote,

“From the resulting Venture Capital strategy, we initiated the Denver “Gazelle” program in 2012 to highlight some of Denver’s most attractive second-stage companies… [Today,] our herd of Gazelles are generating hundreds of millions of dollars for the Denver economy – they have hired scores of new employees into well-paying jobs, expanded into prime office space, and given back to our community as donors, board members, and volunteers.”

As in Denver, local on-the-ground officials see the domino-relationship from high-growth industries to well-paying jobs to an expanding tax base which supports and benefits all levels of society. Over the past decade, great strides have been made to expand venture capital opportunities beyond California, New York and Massachusetts.

According to Pitchbook, the number of funds raised outside those three geographies more than doubled, growing from 136 funds in 2009 to 264 funds in 2018. Yet the toehold remains fragile, as the median venture capital fund outside of the top three states is roughly $20 million assets under management. The VCs in these regions resemble our entrepreneurs in many ways: they are today’s homesteaders, seeking to carve out success in the face of long odds - tapping into that fundamental American spirit to dare. The engine of America’s economy, Silicon Valley, was an orchard 70 years ago. It was built through failure, millions and millions of times over. The seeds of the next Silicon Valley are being tended to in long-quiet factories by entrepreneurs, VCs, and local officials across the nation. While the odds are already long, the CIFA would push them closer to zero, extinguishing the tiny spark that may have one day become a roaring fire of opportunity.

The unintended victims of CIFA's collateral damage would be our nation's entrepreneurs. By effectively reducing the long-term, partnership-based incentives of VCs, less venture capital funds will be raised, ultimately reducing the number of entrepreneurs who receive funding. In fact, since the CIFA does not account for how long an asset is held, entrepreneurs seeking to raise capital for the first time will shoulder the heaviest portion of the burden, as they represent the longest time horizon to realize success. Ultimately, this will serve to further entrench incumbents while stifling innovation and opportunity.

Conclusion

Instead of introducing policies which would harm the innovation economy, we urge congressional leaders to focus on removing barriers to entrepreneurs and VC investors in support of an industry that fuels the economy, drives job growth and creates economic opportunity for Americans. The revenue that would be generated by this attack on the venture capital incentive structure is meager, particularly when compared with its potential damage to societal advancement and the creation of high-paying jobs, the income taxes associated with which would generate far more revenue over the long-term. Increasing taxes on carried interest earned by venture capitalists only serves to undermine the very purpose the CIFA seeks to serve.

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